Active or passive? The answer depends on the fund

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18/09/2017

OPINION | A notable global trend over the last decade has been the evolution in how institutional investors develop and express a well-defined set of investment beliefs.

Australian industry funds have been quick to recognise the advantages of holding a set of investment beliefs that express how the fund thinks about the functioning of financial markets. As trustees and staff change, the investment beliefs can be a compass that helps the fund stay the course amid the turbulence of markets.

Among the more common investment beliefs is an organisational view on the efficiency of markets. Unfortunately, discussion about market efficiency tends to move quickly to the partisan: the indexing (or passive) camp versus stock-picking (or active) camp.

The dogmatic stance of both camps seems at odds with the still-unresolved status of the debate about market efficiency, evidenced by the steady stream of research published in academic and industry journals in the 40 years since Vanguard launched the world’s first index fund. Being less dogmatic and instead thinking about the topic as it relates to an individual fund’s circumstances can be more productive.

At Vanguard, we approach the indexing-vs-active question not as a debate, but as a series of decisions. Broadly, there are three things any fund and its investment committee should examine when making a decision about whether an index-based or active strategy is more appropriate in a particular circumstance: talent, costs and timeframe.

Identifying talent

 For a fund deciding how to access a particular market, the starting question should not be whether indexing or active is right or wrong, good or bad. Instead, the starting point should be looking inward: Does your fund have the resources and expertise necessary to identify outperforming managers?

Generating outperformance is a talent. So too is identifying that talent, a challenge made more difficult by the well-documented lack of persistence in outperformance.

If your fund doesn’t have the resources and expertise to pull it off, that points you to a 100 per cent indexed approach. If it does, that takes you down the path of manager searches and due diligence, using the expertise that resides with your internal staff, perhaps supplemented by an asset consultant or an outsourced provider.

Keeping costs low and exercising patience

The next decision centres on whether you can access that active talent at a relatively low cost, which can be estimated with much greater predictability than the alpha the active manager will hopefully generate.

Paying less for quality investment management has been shown to be an important element in long-term investment success. Remember the adage “alpha is a promise, cost is a certainty” as you negotiate the split of expected outperformance between your members and the active manager.

The third question for a fund to ask is whether its governance budget is better suited to an indexing or an active approach. For this decision, patience is the key component of the governance budget. Patience amid the inconsistency of alpha, and patience that aligns with the investment horizon of active managers.

The decision to go active or passive is about knowing your fund and choosing the right mix of indexing and active for it, to increase the chance of delivering better outcomes for members.

Mary McLaughlin is an investment specialist with Vanguard Australia. She was previously the chief investment officer of the Meat Industry Employee’s Superannuation Fund. This column was prepared ahead of her participation in a panel on the topic of Revisiting the Active vs Passive Debate at the Australian Institute of Superannuation Trustees Super Investment Conference, which was held on the Gold Coast, September 6-8.